Japan’s economy in the July-September quarter expanded 0.4 percent from the previous quarter, or 1.7 at the annualized rate, in price-adjusted real terms, according to a preliminary gross domestic product (GDP) report from the Cabinet Office. That was the fourth consecutive quarter of positive growth, although the pace slowed compared with a larger GDP rise (3.3 percent on an annual basis) in the April-June period. The emerging picture is one of a solid expansion led by domestic demand, with two big engines of growth — consumer spending and business investment — following a firm trend.

The Bank of Japan appears poised to declare an end to deflation perhaps as early as next spring if the current expansion continues. The favorable economic outlook has pushed up stock prices, with daily trading volume exceeding the levels reached in the booming late 1980s. In fact, the economy is in the third expansionary phase since the collapse of the asset-price bubble in 1990, with key sectors of demand reinforcing each other in a long-running virtuous cycle.

There is no assurance, however, that this forward momentum will continue uninterrupted. One major concern is that the economy might slide back into a slump if, for example, the government’s tax-increase policy dampens consumer confidence.

The current robust expansion is supported mainly by the corporate sector, which registered large profit increases in the first half of the fiscal year, April through September. The break-even point, at which sales equal costs, has improved markedly as a result of post-bubble efforts to reduce debt, capacity and payroll. This has made it possible to generate significant profits even if sales increase only slightly.

Contributing to the strong profit performance are steadily rising exports, which are sustained largely by the economic growth of major trading partners, particularly the United States and China. Businesses are investing more of their export profits in new machinery and equipment. Their improved bottom line is also translating into higher household income, thus encouraging consumers to spend more.

Exports, keeping up a favorable trend from previous quarters, increased 2.7 percent in the July-September period. Private-sector capital spending continued to rise for the sixth straight quarter. Consumer spending, which accounts for more than 50 percent of GDP, climbed 0.3 percent. Family incomes also rose gradually, thanks to stepped-up corporate hiring as well as prospective boosts in yearend bonuses (following hikes the year before).

However, there are causes for concern. The first is how economic trends in the U.S. and China will develop. In the U.S., damage from Hurricane Katrina is expected to have a limited impact on the domestic economy. With a housing bubble in the making, however, the Federal Reserve is keeping a tight rein on the money supply. The outgoing Fed chairman, Mr. Alan Greenspan, who has pursued a cautious monetary policy through dialogue with the market, is to be succeeded by Mr. Ben Bernanke in January. If inflationary expectations rise next year, the American economy will probably slow down. If that happens, Japanese exports will be adversely affected.

In China, with its economy continuing to expand at the breakneck speed of 9 percent or so, the negative side of high growth is becoming more pronounced. In urban centers such as Beijing and Shanghai, there is talk of a collapse of the real-estate bubble. Higher oil prices, if they are passed on to refined oil products, will likely cause inflation. China has grown into a world factory and market. If those concerns become real, Japan’s economy will be hit as well, given the growing relationship of interdependence between the two countries.

Instabilities in the export environment are not the only concern. Here at home, the ongoing debate on future tax increases is a major factor contributing to wariness about economic prospects. The possibility cannot be ruled out that the economy might begin to stagnate if a major tax hike is introduced. In fact, a rise in the consumption tax a few years from now is considered unavoidable. Already the government is pushing for a range of tax hikes as if they were faits accomplis.

In 2006, half of the flat-rate tax cuts for national and local income taxes will be abolished, with the other half expected to go in 2007. Also in the works are increases in individual social-security contributions; if implemented, they will add an estimated 3 trillion yen to the household burden. Higher taxes will likely throw cold water on the warming consumer sentiment. There is indeed a real possibility that the economy will slip back into recession if the government relies too heavily on tax increases as a means of reducing the budget deficit.

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